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Economic value added (EVA)

Economic Value Added (EVA)

Economic Value Added (EVA), also known as Economic Profit, measures the return generated by a company or project that exceeds the investors' required rate of return (hurdle rate or cost of capital). It's based on the Residual Income approach. EVA essentially quantifies the value created for investors beyond their minimum expected return.

Core Principles of EVA

  • Projects should generate returns greater than their cost of capital.
  • True profitability occurs when new wealth is created for investors.

Calculating EVA

EVA is calculated by subtracting a finance charge from the net operating profit after tax (NOPAT). The finance charge represents the opportunity cost of the capital invested.

EVA Formula: EVA = NOPAT - (WACC * Capital Invested) Where:

  • EVA = Economic Value Added
  • NOPAT = Net Operating Profit After Tax
  • WACC = Weighted Average Cost of Capital
  • Finance Charge = WACC * Capital Invested

Interpreting EVA

  • Positive EVA: Indicates value creation. The project or company is generating returns above the cost of capital, adding wealth for investors.
  • Negative EVA: Indicates value destruction. The returns are below the cost of capital, meaning the project or company is not generating sufficient returns to satisfy investors' expectations.

Example: Madhuri Ltd.

Problem:

Madhuri Ltd. has invested capital of Rs. 220 crores in assets. The operating income after tax is Rs. 50 crores, and the company's cost of capital is 15%. Calculate EVA.

Solution:

  1. Identify the given values:

    • Capital Invested = Rs. 220 crores
    • NOPAT = Rs. 50 crores
    • WACC = 15%

  2. Apply the EVA formula:

    • EVA = NOPAT - (WACC * Capital Invested)
    • EVA = 50 - (0.15 * 220) (Note: 15% is expressed as a decimal, 0.15)
    • EVA = 50 - 33
    • EVA = Rs. 17 crores

Result:

Madhuri Ltd.'s EVA is Rs. 17 crores. This positive EVA indicates that the company is creating value for its investors. The company's operations are generating returns that exceed the cost of capital by Rs. 17 crores.

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